The China Opportunity: Time to Raise Yuan Exposure

The recent visit to the United States by Chinese president Hu Jintao got a lot of attention and coverage in international media; the fact that so many key people showed up for this meeting shows how important it was for both sides.

For China this visit was important not only for political reasons, but also for building its prestige on the global stage. From an economic point of view, it is able to act from a position of strength. Hu said a few days before the visit that ”the dollar-dominated currency system is a product of the past." At the same time, he said that the Chinese yuan is not yet ready to take over as the new world reserve currency.

It remains to be seen what “not yet ready” means according to the Chinese, but we think China will make a number of very significant changes in the coming years that could have a lot of consequences for the West. The strategy of China for the last 30 years has been to keep its currency artificially low in order to promote exports -- an extremely successful plan. However, this has resulted in significant imbalances in the world economy that sooner or later need to be reversed. China has been accumulating huge amounts of foreign currency reserves, a lot of which was reinvested to buy U.S. treasuries, therefore financing “America Inc.” and other countries which are now running large deficits.

Let’s be clear: China has a number of very serious problems, different from those being faced in Europe or the United States, but equally challenging. The growing imbalance in China between the booming cities and rural areas continues to drive more and more people to the big cities. This growing imbalance is increasing socioeconomic tensions and, coupled with strong inflationary pressure, makes it increasingly difficult for people to make a living, especially in more rural, underdeveloped areas.

There are also large infrastructure and pollution problems in China that need to be solved in the coming years. The key advantage that China has is that it is not a democratic system, and the ruling party can make and implement much needed changes quicker than most other countries. That should help China to continue to grow its economy and keep adding jobs for many millions of people.

I think we are at a very important turning point in the history of China. Going forward, the nation needs to focus more on securing a stable supply of energy, commodities and technology; therefore, its interests are not so heavily biased towards keeping a strong currency anymore. Imports are growing faster than exports, currently at a rate of about 25%, compared to export growth of only about 17%. The overall trade surplus of China has fallen about 9% from the previous year and about 34% from 2009.

There is another factor that needs to be considered: China needs to deal with its inflation problem, and we think it will tackle it from two sides. It will continue to hike interest rates further and therefore control domestic growth and prevent the economy from overheating; at the same time, it will change its currency policy by allowing Chinese companies to hold large foreign currency balances abroad and use them for investment purposes. That will help the Chinese central bank, because it is no longer forced to buy foreign currency reserves and issue cheap domestic currency, which had in turn caused further inflationary pressure in the past. I think that this will help the Chinese central bank to bring inflation under control and will probably allow it to keep further interest hikes moderate and diminish the risk of over-tightening, which should also be positive for Chinese stock prices. So even a small, controlled appreciation of its currency will help China eventually bring growth and inflation at home under control. That’s why we think that China will let its currency appreciate, but, as always it will do so when it serves its purpose -- and that might now be sooner not later.

At the same time, the effects from such developments would be negative for the west. In a time when western governments are so dependent on countries like China to buy their debt, we expect the purchase of government paper to decrease in coming years, which will make it a lot harder and more costly for troubled governments to issue debt. This will eventually lead to higher interest rates in the west, and that would come at a time when inflation is already on the rise because of rising commodity and energy prices. Central banks in the west will probably try to keep short-term rates low for as long as possible in order to stimulate their domestic economies, but the longer-end of the yield curve could experience a significant increase in yields.

We feel that adding further exposure to the Chinese yuan and possibly other Asian currencies is the right thing to do going forward, and also caution investors to hold bonds with long maturities.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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